Policymakers and regulators continually strive to design laws, rules, regulations and other devices to both maintain financial stability and to prevent and mitigate the impact of financial crises. Since the onset of the global financial crisis, they have launched a large number of policy initiatives.
Some of these may yield real benefits in terms of controlling the build-up of systemic risk. However, others may perversely increase systemic risk, particularly when the policies are drawn up without consideration of how they might interact with other rules.
The relative absence of international financial crises over the past few decades lulled policymakers, bankers and academics into complacency. The build-up of systemic risk and the resulting global financial crisis in 2007 therefore caught everybody by surprise.
Outbreaks of systemic risk are expensive for economies and their citizens. Regulators can react to them in a positive or negative way. The SRC will research the options available to the authorities in their aim to balance the need for an efficient financial system with the desire to avoid systemic shocks.
Law of unintended consequences
Policymakers operate under specific mandates and with incomplete information. The new financial regulations they design can often contain embedded “constraints” that lead to unintended consequences and contribute to amplification mechanisms.
Such indirect effects can lead to feedback loops, undesirable coordination, and a lack of diversity within the market. Designing a robust regulatory regime is difficult because it is hard to predict how participants’ individual motives will come together to produce overall behaviour in the market.
Unfortunately, many such rules may be effective in preventing some types of risk whilst at the same time creating new, perhaps hidden, sources of risk. These include:
Tighter bank regulations that led to the emergence of the shadow banking system.
Capital regulations that enabled financial institutions to report healthy capital levels while actually holding decreasing levels of effective capital.
The requirement for all banks to be prudently run, which can create systemic risk if it prompts the sale of risky securities in response to a shock, thus creating downward spirals in asset prices, forcing more sales and further depressing prices, resulting in a crisis.
There are four areas in which SRC researchers will investigate how regulators can produce rules that are more likely to have positive consequences. This will require an interdisciplinary approach and the SRC will therefore bring together researchers from financial economics, law and political science.
1. Political and financial risk
The ongoing interaction between the political system, financial regulators and market participants can create endogenous feedback loops. Before a crisis, politicians are likely to celebrate the build-up of excesses and attempt to prevent any effective action by the regulators. Post crisis, they may want to demonstrate their toughness by clamping down excessively on the financial system. This leads to pro-cyclicality – the correlation between asset prices and the state of the economy that tends to amplify the ups and downs of business cycles.
Our research will seek a better understanding of the policymaking process that encourages laws that may not have been fully thought through, perhaps because of politicians’ short-term electoral horizons or because of the horse-trading that imposes many rules on a single law that is approved without any detailed debate about their precise intended consequences. Researchers will study the political origins of risk, specifically how rules of decision-making influence the distribution of risk among different parties.
2. The law and systemic risk
It is essential that future financial regulation reduces the danger of the way laws are structured adding to systemic risk. Clear, elegant and internationally coordinated laws will remove uncertainty from the financial system.
The Centre’s researchers will investigate how legal rules can be devised that contribute to common knowledge and to transparency where such transparency is beneficial, but that manage to avoid exposing critical information that can reinforce feedback loops.
3. International and domestic regulations
Financial institutions, especially the larger ones, frequently operate internationally, yet financial regulations tend to be domestic. Even within the European Union there is a common market for banking services, but only a partial common regulatory structure and an embryonic banking union. Implementing and enforcing international rules and regulations has always been the hard part, not least for political reasons.
4. Macroprudential regulations
The concept of designing “macroprudential” regulations to reduce the systemic risk within the financial system as a whole has been a focus of attention for regulators since the global financial crisis. While not clearly defined, it captures the desire of society for robust rules to prevent crises and to cope with them when they do happen. They are the obverse of microprudential regulations, which seek to improve the soundness of individual financial institutions.
The development of the macroprudential agenda is very much in the early stages, and the SRC sees its involvement with that debate and engagement with policymakers as a fundamental objective. Particular focuses for research include whether macroprudential tools are sufficient enough to have much of an impact, and whether they can withstand the political pressure for pro-cyclicality and are genuinely counter-cyclical or only create the appearance of counter-cyclicality.
Aims of this research strand
The ultimate goal of this research strand is to develop a lens through which policymakers and regulators can establish regulations that do not create systemic risk, but instead lower the risk of, and mitigate the impact of, future crises. This will be done through thorough research to identify both good and bad examples of regulatory design. The academic research output from the SRC will therefore translate into practical policies and tools for policymakers.